Moody’s decision to strip the UK of its prized AAA rating over concerns of struggling growth prospects and rising government debt could force a sell-off in gilts among risk-conscious institutional investors, economists warn.
The ratings agency cut the country’s rating by one notch to Aa1 on Friday evening, blaming the weak medium-term growth prospects, rising government debt and the subsequent deterioration of the UK’s ability to absorb future shocks using the government’s balance sheet.
However, Moody’s explained the UK’s creditworthiness remained extremely high thanks to its significant credit strengths, including a highly competitive, well-diversified economy, a strong track record of fiscal consolidation and a robust institutional structure; and the longest average maturity structure (15 years) among all highly rated sovereigns globally and the resulting reduced interest rate risk on UK debt.
Schroders European economist Azad Zangana (pictured) said the downgrade came as no surprise, with the economy double-dipping in 2012, and currently on the verge of a triple-dip recession.
He said: “The market reaction this morning suggests there are bigger concerns out there for investors, such as the elections in Italy. Both Standard and Poor’s and Fitch also have the UK’s outlook on negative watch, and so we expect the others to follow suit.
“This could push some investors that are forced to hold AAA-rated assets to sell out of gilts, however, in a world where the pool of AAA-rated assets is shrinking, we do not expect to see much of an impact.”
Zangana added the fallout of the downgrade is more likely to be felt in Westminster rather than the City, where Chancellor George Osborne has used the AAA rating as a benchmark for economic competence.
Redington head of manager research Pete Drewienkiewicz said the downgrade had been well-flagged, so the market impact on gilts had so far been limited. Before the announcement UK debt was trading in line with France, which has already been downgraded, showing that the UK demotion was largely priced in already, he added.
He continued:“The positive moves in risky assets so far in Q1 means it is likely that some UK pension schemes would look to de-risk further on any move higher in gilt yields. The rally in equities and rise in bond yields means these schemes should have seen an improvement in funding ratios and be in a position to remove risk from their portfolio.
“From an LDI perspective, a key issue is the eligibility of gilt collateral. We have seen some banks insert ‘AAA-only’ clauses into Credit Support Annexes, meaning that Friday’s move would have rendered gilts ineligible to be posted as collateral against derivative trade mark-to-markets. We believe that this episode shows clearly why any such clauses should be strongly resisted by UK pension schemes considering embarking upon an LDI strategy.”
Kames Capital head of international rates John McNeill warned the fact that the downgrade of other major sovereign issuers such as the US and France did not lead to a sell-off was of no comfort to the UK, however.
He explained: “The US enjoys the benefits of being the global reserve currency, and major eurozone issuers are to some extent seen as substitutable on the view that they will enjoy mutual support. The UK gilt market and sterling currency have already weakened significantly year-to-date. We believe that this can continue in the short-term. A more major risk to GBP assets would come from any political fall-out. A major deviation from the current fiscal plans or any fracturing in the coalition would be taken badly.”
Comments